Executive Summary

The herding into unmanaged assets is creating distortions, and providing an opportunity for prudent investors.

We sense strong catalysts for change in an investment landscape dominated by groupthink. Pro-growth policies in the U.S should benefit smaller, attractively valued businesses.

“Beware of false knowledge; it is more dangerous than ignorance”

—George Bernard Shaw

Playwright

Fourth Quarter Market Discussion

Unusual times call for unusual measures, and the run for momentum/growth stocks has been anything but normal. With that in mind, we’re taking a different approach to our Market Discussion and letting the data speak for itself. Here is what we’ve learned.

Newton was wrong—what goes up doesn’t have to come down

Don’t believe it? Just look at the performance of the top 10 names in the NASDAQ 100. The group was up 10% for the quarter and an eye-popping 167% over the past three years. If reversion to the mean—gravity in the investment world—actually existed, would investors continue to pour money into these names in hopes of catching a one-way ride to the stratosphere?

Debt is a four-letter word but only to investment prudes

With the average debt-to-capital ratio of the S&P 500 hitting nearly 48% this quarter, it’s clear that value investors who worry about things like balance sheet strength have been getting it all wrong. Financial leverage means nothing. If it did, Tesla, Inc. (TSLA) couldn’t raise cash despite missing production goals and burning through $4.2 billion during the past 12 months.

It’s all about the in crowd

Some of the most widely held Index funds are loaded with zombie companies. For example, more than 30% of the companies in the Russell 2000® are not earning a profit. Despite this, investors continue to flock to unmanaged products, as shown below, regardless of valuations or financial strength of the underlying businesses.

A different perspective

Maybe it’s our contrarian streak but from where we sit, the lessons above ring hollow. While following the crowd above all else has worked in an era of easy money, higher taxes, increased Federal regulation, and sluggish economic growth, we sense a change is coming. Here’s why:

Recent tax reform is pro-growth and should reduce the burden on small companies and encourage business investment.

Interest rates are rising—and so are borrowing costs. As rates continue to climb, we expect companies that have played fast and loose with their balance sheets will face earnings pressure. As rates increase, stratospheric valuations on today’s market darlings could be in jeopardy of severe compression.

Regulatory relief. For the past several years, companies have faced headwinds from heightened regulatory oversight. As the current Administration continues to review and revise existing policies, we expect businesses will find the environment more conducive to growth.

With the above catalysts in mind, the future, in our view, is much brighter for small, reasonably valued companies—especially those that have been left on the sidelines as of late. Growth has had its time in the sun, as the chart shows below, and after more than eight years, we think the tide has begun to turn.

Russell 2000® Value Less Russell 2000® Growth Index

10-Year Annualized Rolling Returns

Source: Furey Research Partners, LLC and Russell®, 12/31/1978 to 12/31/2017, annualized return over rolling 10-year periodsEconomic predictions are based on estimates and are subject to change. Additional information for indices shown at end of material. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Portfolio Activity

Stock selection was strong in a number of areas, with Financials and Industrials holdings leading on the upside. Energy names were down, and the portfolio overall lagged for the period.

Unlocking shareholder value

Long-time holding Hudson Global, Inc. (HSON), a global executive search firm, was up sharply after announcing a plan to sell its recruitment and talent management operations in Europe and Asia Pacific. Following the sale, the company plans to focus its efforts on its growing global recruitment process outsourcing (RPO) business.

The sale is expected to be completed in the first half of 2018 and will leave Hudson debt free and cash rich. RPO is less capital intensive than talent management, and is built on long-term contracts. We believe this new focus should result in more consistent revenue and profitability.

This could be just the first step toward maximizing shareholder value. Despite its recent double-digit run up in share price, we expect to continue to hold shares.

The magic continues

MGIC Investment Corporation (MTG), one of the largest private mortgage insurers in the U.S., was up after reporting better than expected earnings. The business continues to benefit from strong home sales, low unemployment, and an influx of first time buyers—a group that traditionally relies on mortgage insurance to secure loans.

Rising home sales, a robust job market and favorable interest rate trends should continue to boost the private mortgage insurance market. MGIC has begun to stockpile reserves and has been aggressively buying back convertible debt. We would not be surprised to see management buy back shares or initiate a dividend.

Trading at 10x estimated 2018 earnings and only 1.7x tangible book value, the company, in our view, is an undervalued leader in an industry vital to the domestic economy.

A pause in Energy

The portfolio’s Energy holdings lagged the index with a stock specific issue in a single holding accounting for most of the shortfall. The company, a specialty energy pipeline contractor and utility transmission provider, was down for the quarter as cost overruns for three of its pipeline projects took a toll on earnings. The business previously reported a growing backlog of orders. When management announced cost overruns for some recent projects, we decided to look elsewhere for opportunities.

The gift of giving

As investors in small/microcap companies, the team is always on the lookout for niche businesses with unique models that provide an advantage in an industry. The Bancorp, Inc. (TBBK) is a prime example of this approach. The company, with $4+ billion in assets, may be one of the most widely used banks you’ve never heard of. As a white-label operation, TBBK provides behind-the-scenes banking services including prepaid gift and debit cards to more than 100 non-bank partners ranging from PayPal to Verizon. Through the card unit, the company is able to gather significant deposits at extremely low rates and then lend those assets out at open market rates. Additionally, TBBK generates high-margin fee income with each transaction completed using one if its cards.

Despite the competitive advantage of low cost assets, TBBK trades at a 46% discount on tangible book value to its peers and only about half of the multiple paid for its closest competitor.

After the False Knowledge Fades

For the past several years, many investors have come to believe the old rules of investing no longer apply. Instead of losing sleep about the fundamentals of an individual company, the thinking goes, one need only bet on what has worked in the past, regardless of the price paid. As disciplined value investors, this strikes us as knowledge based on a false premise. Fundamentals do matter, and buying companies that can produce earnings growth shouldn’t mean having to pay nosebleed prices or accepting unwarranted balance sheet risk.

We are confident that the current trend will end up on the scrap heap of flawed investment thinking like so many before it. Whether it’s the recently approved tax overhaul providing a boost to small companies, or rising interest rates sparking a renewed focus on balance sheet strength, we believe investors will once again look to fundamentals when choosing where to put their money.

And when the tide turns, we will still be here, leveraging hard work and the knowledge gained through Heartland’s more than 280 years of investment experience. Until then, the team believes market inefficiencies have created dramatic opportunities, particularly among small businesses that are not part of an index.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 50 years of industry experience, 36 at Heartland.

*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988.
**Shown as supplemental information.

The U.S. dollar is the currency used to express performance.

Past performance does not guarantee future results.

The Small Cap Value Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Economic predictions are based on estimates and are subject to change.

There is no guarantee that a particular investment strategy will be successful.

Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”). Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose. The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

Additional Information for Indices in Chart (calendar year returns %):

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

YTD 2017

Russell 2000® Growth Index

20.37

20.17

-17.41

51.19

7.77

13.37

-2.43

31.04

11.26

12.95

1.23

43.09

-22.43

-9.23

-30.26

48.54

14.31

4.15

13.35

7.05

-38.54

34.47

29.09

-2.91

14.59

43.29

5.62

-1.38

11.32

22.17

Russell 2000® Value Index

29.47

12.43

-21.77

41.70

29.14

23.77

-1.54

25.75

21.37

31.78

-6.45

-1.49

22.83

14.02

-11.43

46.03

22.25

4.71

23.48

-9.78

-28.92

20.58

24.50

-5.50

18.05

34.50

4.22

-7.47

31.74

7.84

Source: FactSet Research Systems Inc. and Russell®Past performance does not guarantee future results.